Second Quarter 2017 Review and Third Quarter Outlook

Each quarter we have supplied our clients brief comments about the economy, the markets and our thinking about both. We assemble these comments after we have had an opportunity to review the last quarter’s events, and consider their ramifications going forward. As they are a snapshot in time, these comments can become dated quickly, and so should not be considered investment guidance, nor should they be considered comprehensive of all of our thinking.

Below is that which we have advised our clients after the end of the second quarter in 2017.

The second quarter of 2017 continued many of the trends of the first quarter, in direction if not in pace. The U.S. stock market continued its historic rise by a healthy 3.1%. Growth stocks continued to outpace value stocks 4.4% compared to 1.5%. International stocks, including those in both developed (+6.1%) and emerging markets (+6.4%), continued to outperform the U.S. The U.S aggregate bond index had a total return of 1.5% as yields again fell despite a Fed rate hike on June 14th. Foreign bonds tended to do even better as the dollar depreciated against most other major currencies. Finally, most inflation hedges, including commodities, gold and inflation protected securities had negative returns on the quarter as expectations for inflation diminished.

SECOND QUARTER 2017 COMMENTS

The stock market has continued its march upwards to new records, unemployment has dropped to 4.3%, and the lower ends of the economy are beginning to experience wage growth, all good signs in isolation.

As always, there are reasons for concern.

First, the wage growth is only at the lower end, bolstered by raises in the minimum wage in 21 states and possibly by a reduced supply of undocumented workers as a result of Trump Administration policy. Overall, however, wage growth has remained stagnant as employers are achieving their profitability by using ever better technology, as well as mergers and acquisitions, to exact efficiencies from mid-level wage tiers. And now this year, the declining dollar, the increasing costs of imports it portends, and the resulting inflationary pressures could dampen real (inflation-adjusted) wages. Though consumer confidence is riding high, and the economy appears healthy, only 20% of workers anticipate pay increases, and 10% anticipate pay decreases. If overall wages do fail to rise with a tight labor market, as they have failed to for decades in Japan, then a virtuous cycle of increasing consumer demand for increasing supply can’t achieve lift off. Indeed, retail sales dropped two months in a row this last quarter, especially in autos (as expected, given the sub-prime lending issues that we have reported mimicking those that occurred in the housing market), but also in restaurants, food and beverage.

Second, the tightened job market is potentially impeding prospects for growth, at least in the short term, as employers who collectively have been slow to invest in the nation’s employee base now report a shortage of qualified, drug-free candidates, not to mention difficulties retaining employees they have. As a result of the crackdown in immigration, farmers in some states are reported to have difficulty getting their produce out of the fields. Meanwhile, labor force participation remains at an unhealthy low, suggesting wages or conditions for advancement are insufficient to attract participants into the market.

Third, the rise in the U.S. stock market has been informed heavily by optimism about relatively near term profits, as companies report strong earnings in prospect, with still-low wage pressures, low energy prices, low interest rates fueling their debt, and a declining dollar against foreign currencies making their goods and services more competitive and their foreign profits steeper. Even in the absence of that optimism, 30% of the rise in the U.S. stock market since 2009 is reported to be due to share buybacks, not overall earnings growth; in this time of easy money policy, high profits, and a global savings glut, there’s more where that came from to sustain stock purchases for the time being.

With increasingly concentrated and institutional ownership oriented toward the long term and driving over 90% of trading, stock market volatility has dropped to lows never seen before, and big bets in the futures market suggest a belief that volatility could drop even further. The game has changed; publicly-traded companies are resorbing into the hands of ever fewer investors who have little reason to sell, while fewer and fewer Americans share in capital ownership and its rewards. This process of resorption into sophisticated hands may considerably dampen sell-offs, at least until concern arises about the ability of companies to sustain earnings at these high levels or increase them as expected. Then might volatility return.

The New Administration

While the cheaper dollar may yet fuel growth, especially in manufacture for export, the economic promise of the new administration that fanned optimism in late 2016 and early 2017 has begun to fade. Interest rates which had risen in anticipation of growth and inflation have fallen back, as have growth and inflation estimates themselves. The stock prices of financial companies that might have benefited from those higher interest rates rose and have fallen back. The stock prices of companies positioned to benefit the most from a cut in the corporate tax rate rose, and have fallen back. Industrials anticipating a robust infrastructure program surged, and have fallen back.

The reason for these retrenchments is that the Trump Administration is failing to deliver on promised reforms to healthcare, which in turn is raising doubts about its ability to deliver on reforms to the tax code. Not only have plans for infrastructure spending been delayed, but government spending on transportation and other public works has declined to its lowest level on record as a percentage of GDP. Environmentally-motivated spending in water supply development, in sewage and waste disposal, and in conservation has already dropped precipitously. Though the hiring freeze has been lifted formally, key government positions have gone unfilled, their departments likely paralyzed. In the Treasury, the Secretary has no deputy and has nominated only a fraction of the candidates necessary to fill important posts, suggesting a department dangerously unprepared for the next crisis.

LOOKING AHEAD

A majority of economic forecasters now expect no major fiscal changes to emerge from this administration; consequently, the International Monetary Fund has substantially downgraded projections of growth for the United States, while maintaining global projections of growth based on recovery in Europe and continuing government commitment to growth in China.

But not all is well in China, especially with respect to the accumulation of debt, which has stacked itself up in the tradition of Ponzi. And consumerism has been dampened by the fact that increased personal incomes in China, up 8-fold, have been poured into the purchase of real estate, the value of which could crumble in a debt crisis. As capital borrowed at home has then fled the country, the government has demanded that some of their largest corporations sell off foreign assets to reduce their debts and bring the money back.

Nevertheless, China is emerging quickly to compete with the United States as a global economic power, a position suddenly ceded to it this year by U.S. retrenchment. While the Trump Administration was occupied with its Russian entanglements; withdrew from the Trans-Pacific Partnership; withdrew from the Paris Climate Accords; and stepped up sanctions on Iran, China’s President Xi announced a new global order with Russia’s Putin in attendance. China is now moving quickly not only to expand its geopolitical influence in the Pacific, but is sending a fleet to the Baltic for maneuvers; growing its presence in Iran; and moving to secure its world leadership in clean technology. As its own transformation to a consumer-driven economy has hit bumps in the road, and it continues to struggle in over-capacity, China is enacting a vigorous effort to devote both its production and lending capacity to the construction of infrastructure across south Asia, under the name One Belt, One Road.

As prospects for accelerated economic growth in America diminish, fortunately our market economy does have some self-correcting mechanisms. The dollar has fallen 9% this year to reflect fading interest rates and fading potential for investment relative to the rest of the world. But that fall in itself renders American goods and services cheaper than they were and more attractive to purchase, and therefore offers the potential to boost manufacturing to supply an increase in foreign demand for our product. Also, in the face of a tightened labor market, displaced labor from the auto industry and from retail may be available then to be redeployed into sectors where hiring is taking place. (However, government funds for job retraining have been drastically reduced and many of those sectors of growth are low-wage anyway.) As retail suffers from struggling consumerism and potentially increasing import prices, shopping malls are being repurposed as healthcare facilities and as warehousing for same-day delivery of products bought on-line, both ways of leveraging their spacious facilities and convenient locations. Ours is still a vital economy capable of adjusting.

The danger though, as we’ve discussed before, is that in the absence of increasing wages, it is mounting debt that has produced growth in the United States, and not just through student and auto loans and credit cards (all of which are increasing in rates of default). While farm incomes have plummeted by nearly half since 2013, for example, farm debt is running at levels not seen since the 80’s. Firms like John Deere are making a significant portion of profits from lending, which is being used to support operational needs like seeds and fertilizer, not capital equipment. Propping up profits in manufacturing with financing activity was a hallmark of the financial crisis.

In sum, then, the world economy is forging on here and abroad, still sustained by the use of debt to fuel otherwise struggling demand. Global inflation is now at its lowest since 2009, when deflation was rearing its ugly head. Central banks in Japan, Europe and India are all still easing interest rates. With debt high, and interest rates low, should the inevitable recession appear any time soon, neither government spending nor central bank easing may be available in sufficient volume. Consequently, central banks now are likely to proceed only very slowly and carefully in taking their own foot off the gas, fearful of the consequences of any form of economic slow-down.

The Stock Market

Ironically, the mediocre economic outlook is not bad for stocks. Earnings at large U.S. multinational companies are hanging in, and may continue to under the conditions of global growth and a declining dollar. Low interest rates on bonds and cash, both resulting from slow growth and low inflation, may continue to support stock prices by offering poor substitutes. What’s more, though retail investors have been net sellers of stock still, continued high levels of corporate profit and continued liquidity from central banks are both likely to continue to fuel corporate share repurchases for the foreseeable future, providing support for stock prices.

IN SUMMARY

Record highs in the stock market are not unusual; after all, the general direction of the market over the long term has always been upward. In our view, these price levels are justified for now, provided that earnings are really sustainable, and are not eventually depleted by a spend-down of the consumer’s financial wherewithal or disrupted seriously by dramatic geopolitical events.

Best Regards,

Chris Douglas Tom Gray

Managing Director Managing Director

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The thoughts expressed on this web page provide insight into the investment and/or financial planning considerations of members of C.H. Douglas & Gray, LLC, a firm providing fee-only financial advice in asset management to households and institutions in states in which it is registered. Specific investment advice is available only to clients of the firm. Contact C.H. Douglas & Gray for more information.